Morality and Investment Banking

Investment banks deserve less respect than a suburban bookmaker, according to key U.S. senators, and will face new rules to modify their behaviour. They will have to show their social utility.

The U.S. senate investigations panel put Goldman Sachs firmly in its sights last week. It pummelled some of the firm's most senior executives as well as several relatively junior and past employees for nearly11 hours.

Senators had seen evidence of billions of dollars being punted against the U.S. housing market. Unlike the senators' own constituents, Goldman Sachs executives seemed to have emerged from the 2008 financial crisis wealthier than ever. This seemed to enrage them more than any possible wrongdoing .

The senators had access to documents showing how Goldman Sachs had begun paring back long positions in residential mortgages in 2007 to such an extent that, by 2008, their mortgage trading desk could be profitable.

They did not sell the inventory of securities they had bought in a rising market. Rather, according to the evidence presented, they began accumulating short positions to offset the inventory. The magnitude of these short positions particularly attracted the ire of committee chairman Senator Carl Levin who was relentless in his criticism.

Worse still in the eyes of the senators, the trading desk did not sell real portfolios but used synthetic CDOs to help whittle away the risk of being long in a falling market.

A synthetic CDO is akin to a futures contract. It has no cash equivalent. Its value is tagged to a benchmark portfolio with counterparties effectively liable for the difference when prices of securities in the benchmark move.

For anyone to buy a synthetic CDO in anticipation of the underlying securities rising in value another party must be selling. One of the complaints levelled against Goldman Sachs by Senator Levin was that the firm promoted products designed to fail and, in doing so, favoured one client over another.

As long as its sales force could foist the synthetic product on an unsuspecting client, the seller would almost certainly make money. This, Senator Levin and his colleagues from both parties deemed unacceptable.

The Goldman Sachs defence was twofold. Firstly, it claimed, there was no certainty in financial markets. They could move in either direction. Secondly, the firm only did business with professional investors. They understood the risks they were taking and were aware of their obligations to undertake due diligence to assure themselves of the quality of what they were buying.

All the senators dismissed this argument with several likening what Goldman Sachs had been doing to rigging a Las Vegas gaming table or poker machine.

Midwestern senators representing farmers refused to accept that a synthetic CDO was anything like a futures contract for beef, lumber or corn. Their constituents had long used futures markets for hedging. It was different when salt of the earth constituents sold a futures contract to protect their prospective income. Goldman Sachs had no such moral purpose. Their instruments were nothing more than a bet on which way a market would move.

That might have been bad enough but, at the same time, the house was rigging the poker machine even after money was put into the slot to ensure that the hapless punter was always going to lose, according to several of the senate inquisitors.

Worse still, one senator described what the firm was doing as betting on the demise of companies and not on their success. In one direction lay treachery; in the other was moral rectitude.

Markets eventually get used to whatever new regulations are put in place, sometimes by working around them to avert their intended impact. The direction in which U.S. legislators are heading is potentially more than usually disruptive to the financial markets.

New financial products would have to conform to a social purpose test. Promoters would have to demonstrate a valid need. It would no longer be enough for counterparties to agree to accept risks no matter how open eyed they had been.

Disclosure obligations in secondary markets would converge on the currently tougher disclosure requirements in new issue markets.

Even professional investors would be able to reserve for themselves a right of complaint if the promoter of a security profits at their expense.

Eventually, under such a regime, securities of any sort will only be traded through highly regulated markets with clearing facilities. Customized products might not disappear but would become more expensive, at least within the USA.

Where customized products are allowed, market liquidity is likely to be reduced. Lower liquidity is likely to translate into more expensive financing.

Companies, in particular, would suffer the consequences. They have been leading the push in the past decade for investment banks to evolve from institutions arranging finance on their behalf to institutions assuming the risks of financial transactions.

Companies have had their risks reduced but the investment banks have turned into risk managers using a full array of instruments to cope. Now they are being told they went too far. However, without this evolution, corporate finance costs would have been higher than they have been.

Despite their interest in the outcome, corporates are staying well clear of the debate. Few, if any, significant business executives from outside the financial community are showing any inclination to defend Goldman Sachs.

If history is any guide, these same companies will be complaining in another 10 years or so about the highly burdensome 2010 anti investment banking legislation with which thy have to contend. They will be lobbying furiously to have rules rescinded that unduly restrict their access to globally competitive finance.

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